A mutual fund is the most popular form of a pooled investment known today. They are designed for people who want to have their money professionally managed at a fairly reasonable cost. In addition to professional management, they give an investor convenience, diversification, record keeping, tax reporting, and safekeeping of securities.
How do mutual funds make money?
Mutual funds make money in several ways. The main way is from internal fees that are called expense ratios. Expense ratio sounds a lot better than FEES, right? But it’s the same thing. It’s a percentage of the funds assets that are taken out every day, and it’s how the mutual fund company stays in business. You never see these fees come out, but they definitely affect your annual returns. You want to try to make sure your expense ratios are around 1% or less per year. Some specialty funds are going to be higher, but for the most part you should try to buy funds that are under 1%. Funds are required by law to produce a document called a prospectus, which no one ever reads, that tells you important information about the fund. Fortunately, Morningstar reports most of this same information in a much easier to understand way. The best mutual funds will keep these internal costs to a minimum.
What about commissions?
This is an important one. Many mutual funds sold today by bank brokers and full-cost brokers like Merrill Lynch and Edward Jones have commissions, or loads. Loaded funds commissions can vary, but most are between 1% and 5.75%. That means for every $1000 you invest, $45 to $57.50 could be coming out for a commission to the broker, and the rest gets invested into your account. That’s not such a bad thing if the broker getting paid is actually helping you manage your account of mutual funds. Loaded funds can have either front-end or back-end commissions. Front-end means you pay it when you go into the fund with new money, these are called A share funds. Back-end means you pay it when you eventually sell the shares, these are called B share funds. With a B share, the back-end commission gradually declines the longer you hold it. It’s usually completely gone after 7 years. The problem is, B share funds have much higher internal expense ratios, sometimes 2.5% per year. This is how they make up for the commission that they paid the broker when you bought it. If you’re going to buy a loaded fund, you should NOT buy a B share. The other option is a C share. C share funds have no commission when you buy it, and a 1% back-end commission if you sell within the first year. The best mutual funds will have little or no commission on them.
What are No-Load funds?
No load funds are funds that have no commission for the investor to pay at all. So every $1 that you invest goes right into the fund. Some famous no-load mutual fund companies are Fidelity Investments, Vanguard, and the Dimensional Funds. The only way a no-load mutual fund makes money is from the internal expense ratios. But that doesn’t mean that their expense ratios are higher. In fact, quite the opposite can be true. No-load funds are in our opinion are some of the best mutual funds available today.